By Kyle A. Krasa, Esq. and Travis H. Long, CPA
A very common Estate Planning technique for married couples is an “A/B Trust.” The ideas behind the A/B Trust are to preserve the Estate Tax Exemption of the first spouse to die and to retain a degree of control over the deceased spouse’s share of the estate, protecting the deceased spouse’s beneficiaries from the whims of the surviving spouse. Upon the death of the first spouse, the trust sub-divides into an “A Trust” (also known as a “Survivor’s Trust”) and a “B Trust” (also known as an “Exemption Trust,” a “Bypass Trust,” or a “Family Trust”).
Many surviving spouses who have A/B Trusts either do not realize that upon the death of the first spouse they need to physically split the assets between the A and B Trusts or consciously neglect to split the assets because they feel it’s unnecessary, expensive, or time consuming. Occasionally, a surviving spouse with an A/B Trust will realize years after the death of the first spouse that the A/B split was never completed. Alternatively, the surviving children of a deceased couple who had an A/B Trust where no A/B split was completed upon the death of the first spouse realize the estate was never settled. In both cases, the A/B split should have been done upon the death of the first spouse and the task at hand is to figure out how to handle the situation.
The question becomes whether the assets should be split between the A and B Trusts now, correcting the mistake of neglecting to split the assets upon the first spouse’s death (known as “stale trust funding”), or whether the A/B provisions of the trust can be ignored.
Many people upon first blush will want to ignore the A/B provisions of the trust. After all, trying to correct a mistake made many years ago will undoubtedly create additional legal fees, accounting and tax preparation fees, time, effort, and complications. It is much easier to sweep these problems under the proverbial rug. However, there are many legal and tax issues that must be carefully considered before deciding to ignore what can be a significant problem.
First, the tax purpose of the A/B split is to preserve the first spouse’s Estate Tax Exemption. If the estate is larger than one spouse’s Estate Tax Exemption, by not performing a stale A/B split, you will be forgoing perhaps hundreds of thousands of dollars in Estate Tax savings.
Second, the beneficiaries of the B Trust might be different than the beneficiaries of the A Trust. If you ignore the A/B split, are you disenfranchising the B Trust beneficiaries?
Third, the Trustee has a fiduciary duty to carry out the terms of the trust and is thus legally required to perform the A/B split if that is what the trust dictates. The Trustee could face serious legal consequences by ignoring the law.
Fourth, the trustee could be held liable for tax returns that were not properly filed.
Normally, an administrative trust tax return is filed for any income generated by the decedent’s assets between the date of death and the date the A and B sub-trusts are funded. After that point, the A trust income gets reported on the surviving spouse’s 1040, and the B trust income is reported on a form 1041 tax return each year going forward.
What happens when the funding is not done for years? Most people in these situations continue to report all the income on their 1040s after their spouse passed away, as if nothing had happened. This is incorrect.
So, do you have to go back and file tax returns for the B trust for all those years? The IRS generally takes the position that since the B trust was never funded, there are no tax returns needed for that trust. Once you fund the trust, then you start filing returns for it, even if years later. However, at the same time, the IRS views the decedent’s share of assets as having belonged to an administrative trust since the date of death – still waiting to be properly distributed. This administrative trust should have had tax returns filed every year. It is further complicated when those assets are used, retitled, sold, and mixed with other assets improperly.
There are generally three different approaches to solving the return filing problem. The first is to go back and file tax returns for the administrative trust dating back to the date of death. This is the safest route, but is probably the most expensive, and may be impossible depending on the records available. You also have the problem of potentially amending all your 1040s that were not properly prepared as a result.
The second approach some practitioners use is to essentially file blank 1041s dating back to the date of death and include a statement with each return that all the income was reported on the surviving spouse’s 1040. The problem with this is that the amount of tax owed, besides being paid on behalf of the wrong taxable entity, is rarely the same. Filing blank 1041s clearly brings the issue front and center to the IRS, but, it could also bring closure to the issue.
The third approach some practitioners take is to not file any administrative trust returns for the past, and just start filing returns for the B trust going forward. This approach has risks because required returns are never filed, and therefore the statute of limitations never begins. The issue could theoretically pop-up at any time in the future without the appearance of being forthright.
It is clear there are many issues to consider in a stale trust administration. If you find yourself in this situation as a surviving spouse or you think you may be the future beneficiary of funds from a stale trust, it would behoove you to seek qualified professional advice to determine if or to what extent you could be affected, and what your options are. The most common reaction is to ignore it and hope it goes away or think someone else will deal with it later. Unfortunately, if there is an issue, it almost always resurfaces upon the death of the second spouse, at which point it gets more expensive to handle, is more likely to cause fighting between beneficiaries, or creates an irreversible financial disaster for the beneficiaries. Fortunately, there are solutions if you act today!
IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.
KRASA LAW is located at 704-D Forest Avenue, PG, and Kyle can be reached at 831-920-0205.
Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.